Holding or folding option spreads
By Bill BurtonUnlike the stock and futures markets, the option market isn’t ruled solely by price. Options traders need to focus on three major forces: underlying price, time to expiration, and implied volatility. Each determines one aspect of a trade’s risk and potential profitability, and their mutual interaction define the yin and yang of options trading.
Paying close attention to the first two forces — price and time — can help lower risk substantially, especially when trading options with “ratio backspreads,” which are particularly vulnerable to time decay.
Before detailing this strategy, it’s necessary to understand how options are priced.
Option pricing brieferOptions prices have two main components: intrinsic value and extrinsic value. Intrinsic value is the positive difference between the underlying security’s price and the option’s strike price. For example, if International Business Machines (IBM) is trading at $128, a $125-strike call that costs $4.70 contains $3 of intrinsic value (128 – 125). Intrinsic values range from zero for an out-of-the-money (OTM) option to almost the entire value of a deep in-the-money (ITM) option.
Extrinsic value, or “time premium,” is simply the difference between an option’s price and its intrinsic value. For example, the IBM $125-strike call has an extrinsic value of $1.70 (4.70 – 3). Extrinsic value is largely determined by two variables: implied volatility (IV) and time to expiration. These factors can account for the entire cost of an OTM option or just a small portion of a deep ITM one.
Implied volatility can move up or down (or not at all), and reflects both the market’s general sentiment and forecasts of the underlying instrument’s statistical (historical) volatility, which is based on its actual price moves. New traders routinely underestimate IV’s impact on option pricing.
Unlike changes in underlying price and IV, the passage of time is unique, because it moves only in one direction and can’t be stopped — the reason options are “wasting assets.” Time decay is not uniform over an option’s life; it accelerates rapidly as expiration approaches.
Accelerating time decay can either hurt or help specific trades, depending on whether you buy more option premium than you sell. And knowing how time influences options positions can help you control risk.
Many traders use price stops to exit trades and limit losses or hold onto profits. Options traders need to pay attention to price and time. Let’s examine two options positions that benefit from so-called time stops, which close trades at a certain point — often halfway to expiration — if the balance between risk and reward becomes unfavorable.
Of the dozens of options strategies, ratio backspreads are particularly vulnerable to time decay, but “time stops” can dramatically reduce their risk.
For the complete article, see the October 2010 issue of Active Trader magazine. Click here to subscribe.
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